Recent Turmoil in Emerging Markets and the Behavior of Country-Fund Discounts: Renewing the Puzzle of the Pricing of Closed-End Mutual Funds

WP/95/68-EA
Recent Turmoil in Emerging Markets and the Behavior of
Country Fund Discounts: Renewing the Puzzle of the Pricing
of Closed-End Mutual Funds by Charles Kramer and R. Todd Smith

It is well known that shares of closed-end funds usually trade at
discounts to the net asset value of the underlying basket of securities.
However, closed-end funds do, on occasion, trade at premiums. Although a
wide variety of explanations have been advanced to explain deviations of
price and net asset value, only the investor sentiment hypothesis of Lee,
Shleifer, and Thaler (1990) can potentially account for the dynamics of such
deviations. Their argument is that investors in closed-end funds--mostly
small investors--trade on the basis of factors besides information, in
particular, on the basis of sentiment. This hypothesis could explain why
fund prices deviate from the value of the underlying assets: when small
investors are pessimistic, funds trade at a discount, and when they are
optimistic, funds trade at a premium.

While this hypothesis has gained much currency in its application to
pricing of closed-end funds that invest in U.S. securities, it is hard to
see how it could explain recent movements in closed-end country funds,
especially Mexico funds. The paper notes that, in particular, closed-end
funds dedicated to Mexico and other Latin American stock markets developed
large premius after the December 1994 devaluation of the Mexican peso andthe subsequent financial crisis. The investor sentiment hypothesis could
explain these events only by suggesting that investors are optimistic about
Mexican stocks; this possibility seems unlikely given the facts surrounding
the devaluation.

The recent crisis in Mexico erupted with the announcement on
December 20, 1994 by Mexican authorities that the peso would be devalued
immediately by 13 percent. Although there had been a gradual deterioration
in Mexican financial markets throughout 1994, by most accounts critical
information (notably, on foreign reserves) that pointed to the seriousness
of the problem was lacking in the run-up to the devaluation, and
international investors were caught off guard by the devaluation. The
information contained in the announcement caused enormous negative
adjustments in Mexican financial markets.

It seems reasonable to conclude that this shock induced pessimism in
investors in closed-end Mexico funds about securities returns in Mexico, and
thus, according to Lee, Shleifer, and Thaler, would have widened the
discount on Mexico closed-end funds. In fact, after December 20, modest
discounts turned into very large premiums for all closed-end Mexico funds.
Their paper argues instead that a sensible explanation for recent dynamics
of closed-end country funds is that investors in these funds are loss
averse, which implies that they do not want to realize paper losses on their
closed-end fund shares. This aversion to losses works to put a drag on the
downward movement in closed-end fund prices.